HANOVER CAPITAL MORTGAGE HOLDINGS INC - 10-Q Quarterly Report

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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549

FORM 10-Q

[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2003

OR

[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

FOR THE TRANSITION PERIOD FROM TO

COMMISSION FILE NUMBER: 001-13417

HANOVER CAPITAL MORTGAGE HOLDINGS, INC.
(Exact name of registrant as specified in its charter)

MARYLAND 13-3950486

(State or other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification No.)

379 THORNALL STREET, EDISON, NEW JERSEY 08837
(Address of principal executive offices) (Zip Code)

(732) 548-0101
(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)

Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]

Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X]

The registrant had 4,577,348 shares of common stock outstanding as of
August 14, 2003.

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HANOVER CAPITAL MORTGAGE HOLDINGS, INC.

FORM 10-Q

FOR THE QUARTER ENDED JUNE 30, 2003

INDEX

1

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE DATA)

See notes to consolidated financial statements
2

HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)

See notes to consolidated financial statements
3

HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
SIX MONTHS ENDED JUNE 30, 2003
(IN THOUSANDS, EXCEPT SHARE DATA)
(UNAUDITED)

See notes to consolidated financial statements

4

HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
(UNAUDITED)

See notes to consolidated financial statements
5

HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

1. ORGANIZATION AND BASIS OF PRESENTATION

The interim consolidated financial statements of Hanover Capital Mortgage
Holdings, Inc. ("Hanover") and subsidiaries include the accounts of Hanover and
its wholly-owned and equity-owned subsidiaries. These interim consolidated
financial statements should be read in conjunction with Hanover's Annual Report
on Form 10-K for the year ended December 31, 2002. The interim consolidated
financial statements reflect all normal and recurring adjustments which are, in
the opinion of management, considered necessary for a fair presentation of the
financial condition and results of operations for the periods presented. There
were no adjustments of a non-recurring nature recorded during the three and six
months ended June 30, 2003. The interim results of operations presented are not
necessarily indicative of the results for the full year. When necessary,
reclassifications have been made to conform to current period presentation.

Hanover was incorporated in Maryland on June 10, 1997. Hanover is a real
estate investment trust ("REIT"), formed to operate as a specialty finance
company. Hanover has two primary subsidiaries: Hanover Capital Partners Ltd.
("HCP") and HanoverTrade, Inc. ("HT"). When we refer to the "Company," we mean
Hanover together with its consolidated and unconsolidated subsidiaries.

Pursuant to a Stock Purchase Agreement effective July 1, 2002 and approved
by a special committee of disinterested members of its Board of Directors,
Hanover acquired 100% of the outstanding common stock of each of HT, HCP and
Hanover Capital Partners 2, Inc. ("HCP-2"), a previously inactive subsidiary.
Hanover had previously owned 100% of the non-voting preferred stock, but none of
the voting common stock, of each of HT, HCP and HCP-2. This ownership structure
was established in order to satisfy tax laws governing Hanover's status as a
REIT. Changes in the tax laws made it possible for Hanover to acquire voting
control of HT, HCP and HCP-2 and operate under new rules permitting REITs to
wholly own subsidiaries such as HT, HCP and HCP-2. Therefore, as of July 1,
2002, Hanover owns 100% of the outstanding capital stock of each of HT, HCP and
HCP-2, and for periods ending after June 30, 2002, Hanover's financial
statements will be consolidated with the financial statements of HT, HCP and
HCP-2.

The Company is engaged in three principal businesses, which are conducted
through its three primary operating units: Hanover, HCP and HT. The principal
business strategy of Hanover is to invest in mortgage-backed securities ("MBS")
and mortgage loans for its own account, and for third parties. The principal
business strategy of HCP is to generate consulting and other fee income by
providing consulting and due diligence services, focusing on loan sale advisory,
loan file due diligence reviews, staffing solutions and mortgage assignment and
collateral rectification services. The principal business activity of HT is to
generate fee income by operating an Internet exchange for trading mortgage
loans, mortgage servicing rights and related assets, and providing
state-of-the-art technologies supported by experienced valuation, operations and
trading professionals. HanoverTrade also provides a full range of asset
valuation, analysis and marketing services for performing, sub-performing and
non-performing assets, whole loans and participations, Community Reinvestment
Act loans, and mortgage servicing rights. Hanover also maintains an equity
investment in HDMF-I LLC ("HDMF-I"). HDMF-I was organized in August 2001 to
purchase, service, manage and ultimately re-sell or otherwise liquidate pools of
primarily sub- and non-performing one-to-four family residential mortgage loans.

The Company's principal business objective is to generate net interest
income on its portfolio of mortgage securities and mortgage loans and to
generate fee income through HCP, HT and third party asset-management contracts.

In January 2003, the FASB issued FIN 46, Consolidation of Variable Interest
Entities -- an interpretation of ARB No. 51, which addresses consolidation of
variable interest entities. FIN 46 expands the criteria for consideration in
determining whether a variable interest entity should be consolidated by a
business entity, and requires existing unconsolidated variable interest entities
(which include, but are not limited to, Special

6

HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Purpose Entities, or SPEs) to be consolidated by their primary beneficiaries if
the entities do not effectively disperse risks among parties involved. This
interpretation applies immediately to variable interest entities created after
January 31, 2003, and to variable interest entities in which an enterprise
obtains an interest after that date. It applies in the first fiscal year or
interim period beginning after June 15, 2003, to variable interest entities in
which an enterprise holds a variable interest that it acquired before February
1, 2003. The adoption of FIN 46 is not expected to have a material effect on the
Company's consolidated financial statements.

In May 2003, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards No. 150, Accounting for Certain
Financial Instruments with Characteristics of both Liabilities and Equity ("SFAS
150"). SFAS 150 establishes standards for how an issuer classifies and measures
certain financial instruments with characteristics of both liabilities and
equity and requires a financial instrument that is within its scope to be
classified as a liability (or an asset in some circumstances). Many of those
instruments were previously classified as equity under previous guidance. This
statement is effective for financial instruments entered into or modified after
May 31, 2003, and otherwise is effective at the beginning of the first interim
period beginning after June 15, 2003. It is to be implemented by reporting the
cumulative effect of a change in an accounting principle for financial
instruments created before the issuance date of this statement and still
existing at the beginning of the interim period of adoption. The Company's
adoption of SFAS 150 is not expected to have a material effect on the Company's
consolidated financial statements.

In May 2003, the Emerging Issue Task Force ("EITF") issued Issue No. 00-21
Accounting for Revenue Arrangements with Multiple Deliverables. EITF Issue No.
00-21 provides guidance on how to determine when an arrangement that involves
multiple revenue-generating activities or deliverables should be divided into
separate units of accounting or revenue recognition purposes, and if this
division is required, how the arrangement consideration should be allocated
among the separate units of accounting. The guidance in this Issue is effective
for revenue arrangements entered into in fiscal periods beginning after June 15,
2003. The Company does not expect the provisions of this Issue to have a
material effect on the Company's consolidated financial statements.

7

HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

2. MORTGAGE LOANS

MORTGAGE LOANS HELD FOR SALE

MORTGAGE LOANS SECURITIZED IN COLLATERALIZED MORTGAGE OBLIGATIONS

Hanover's securitizations were issued with various call provisions,
generally allowing for the termination of the securitization at the earlier of a
certain date or when the outstanding collateral balance is less than a certain
percentage of the original collateral balance. As of June 30, 2003, Groups 2 and
3, together, of Hanover's 1999-A securitization is callable. We are currently
evaluating the economic feasibility of calling 1999-A.

8

HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

3. MORTGAGE SECURITIES

FIXED-RATE AGENCY MORTGAGE-BACKED SECURITIES

As of December 31, 2002, there were no fixed-rate agency mortgage-backed
securities.

FIXED-RATE SUBORDINATE MORTGAGE-BACKED SECURITIES

ADJUSTABLE-RATE SUBORDINATE MORTGAGE-BACKED SECURITIES

9

HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

DERIVATIVE MORTGAGE-BACKED SECURITIES

As of June 30, 2003, there were no derivative mortgage-backed securities.

4. LOAN LOSS ALLOWANCE

5. NOTES RECEIVABLE AND DUE FROM AFFILIATE

As of June 30, 2003, Hanover had the following loans outstanding to four
executive officers ("Principals"):

NOTES RECEIVABLE
(DOLLARS IN THOUSANDS)

Pursuant to certain performance targets set in 2002 and met during the
second quarter of 2003, one-third, or $583,333, of Principals' loans were
forgiven resulting in a reduction in additional paid-in capital as of June 30,
2003.

The loans to Principals are secured solely by 116,667 shares of Hanover's
common stock owned by the Principals, collectively.

Included in other assets in the Consolidated Balance Sheet is a receivable
from HDMF-I of approximately $64,500 as of June 30, 2003.

10

HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

6. REVERSE REPURCHASE AGREEMENTS

Information pertaining to individual reverse repurchase agreement lenders
at June 30, 2003 is summarized as follows (dollars in thousands):

With the exception of the first facility listed, all of the reverse
repurchase borrowings are pursuant to uncommitted financing arrangements which
are typically renewed every 30 days. The first facility listed matures on April
26, 2004.

7. DERIVATIVE INSTRUMENTS

INTEREST RATE CAPS (FREESTANDING DERIVATIVES)

From time to time the Company buys interest rate caps when it finances
fixed-rate assets with floating-rate reverse repurchase agreements and CMOs. At
June 30, 2003, the Company had two interest rate caps designated as freestanding
derivatives. The objective in entering into these instruments is to protect the
net interest margin, which represents the difference between the interest earned
on assets and the interest paid on debt. Payments received on the interest rate
caps are expected to partially offset increases in interest expense that could
result from increases in interest rates. Currently, both interest rate caps are
indexed to LIBOR. The Company considers its interest rate caps designated as
freestanding derivatives additional protection against the net interest margin
although they have not been specifically designated hedging instruments for
accounting purposes. The Company did not recognize any gains or losses for the
three months ended June 30, 2003 in the accompanying Consolidated Statement of
Income for changes in the fair value of interest rate caps designated as
freestanding derivatives. All of these interest rate caps relate to the payment
of variable interest on existing financial instruments. As of June 30, 2003, the
fair value of the Company's interest rate caps was $1,000.

FORWARD SALES OF AGENCY SECURITIES (FREESTANDING DERIVATIVES)

From time to time, the Company enters into forward sales of government
agency guaranteed securities, known as "Agency" securities to manage the
exposure to changes in the value of securities classified as "trading
securities." The Company considers these forward sales to be freestanding
derivatives. The objective is to offset gains or losses on the trading
securities with comparable losses or gains on the forward sales. Generally,
changes in the value of the trading securities are caused by changes in interest
rates, changes in the market for MBS, and changes in the credit quality of the
asset. Changes in interest rates and changes in the market for MBS will also
affect the value of the forward sales of Agency securities. (The Company does
not attempt to hedge changes in the credit quality of individual assets.) The
Company calculates the expected impact that changes in interest rates and the
market will have on the price of the trading securities and the

11

HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

forward sales. Using this information, the Company determines the amount of
forward sales required to offset the expected gains or losses on trading
securities with comparable losses or gains on the forward sales. The Company
marks to market the gain or loss on all of the trading securities and all of the
freestanding derivatives in each reporting period. The mark to market on the
trading securities is reported as a component of gain (loss) on mark to market
of mortgage assets in the accompanying Consolidated Statements of Income. The
mark to market on the freestanding derivatives is reported as a component of
other income (loss) in the accompanying Consolidated Statements of Income. The
Company realized net income on these freestanding derivatives of $6,200 for the
three and six months ended June 30, 2003. As of June 30, 2003, the fair value of
the Company's two forward sales of Agency MBS was $6,200.

8. STOCKHOLDERS' EQUITY AND EARNINGS PER SHARE

In August 2000, the Board of Directors of Hanover authorized a share
repurchase program pursuant to which Hanover is authorized to repurchase up to
1,000,000 shares of its outstanding common stock, from time to time, in open
market transactions at a total cost not to exceed $3,000,000. In addition, on
August 7, 2001, the Board of Directors of Hanover authorized the repurchase of
60,000 shares of its outstanding common stock. During the six months ended June
30, 2003, the Company repurchased 2,000 shares of its common stock in open
market transactions through one of its subsidiaries at $7.73 per share for a
total cost of $15,000. As of June 30, 2003, Hanover had remaining authority to
purchase up to 501,025 shares for not more than $137,000 under the 2000 share
repurchase program and 1,000 shares under the 2001 share repurchase
authorization.

On February 20, 2002, the Board of Directors of Hanover authorized the
repurchase of up to 18,166 shares outstanding as a result of exercise of stock
option grants prior to the registration of the shares covered by the 1999 Equity
Incentive Plan. As of June 30, 2003, Hanover had remaining authority to purchase
up to 2,500 shares under the 2002 share repurchase authorization.

On January 19, 2001, Hanover's affiliate, HT, hired 18 employees of Pamex
Capital Partners LLC and purchased all of Pamex's assets. The purchase price
consisted of $850,000 in cash paid at closing, plus an earn-out of between
$1,250,000 and $1,500,000 payable over three years in shares of Hanover common
stock. The earn-out is based on performance targets. The performance targets for
the first two years were met during 2002 and 2001 and $500,000 was accrued by HT
each year. On February 24, 2003, Hanover made a capital contribution to HT of
$75,000 in cash and 60,180 shares of Hanover common stock with a then fair
market value of $457,970. On February 19, 2002, Hanover made a capital
contribution of 63,577 shares of Hanover common stock with a then fair market
value of $470,470.

On February 21, 2003, the Board of Directors of Hanover authorized an April
4, 2003 repurchase of 29,276 shares of its common stock from two Principals;
both of whom used all proceeds to partially repay their outstanding indebtedness
to Hanover.

12

HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Calculations for earnings per share are shown below (dollars in thousands,
except per share data):

9. HANOVER STOCK OPTION PLANS

On February 25, 2003, Hanover issued options, under the 1999 Equity
Incentive Plan, to purchase 30,000 shares of its common stock with an exercise
price of $7.69 per share in satisfaction of certain terms of the purchase
agreement between HT and Pamex. The stock options expire on February 24, 2008.

On May 15, 2003, Hanover issued options, under the 1997 Executive and
Non-Employee Director Stock Option Plan, to purchase 4,000 shares of its common
stock with an exercise price of $10.26 per share in connection with the
re-election of two non-employee directors to the Board of Directors. The stock
options expire on May 14, 2013.

The per share weighted average fair value of stock options granted for the
six months ended June 30, 2003 was $0.40, at the date of grant using the
Black-Scholes option-pricing model with the following weighted-average
assumptions:

Expected life (years)............................ 6
Risk-free interest rate.......................... 3.79%
Volatility....................................... 27.85%
Expected dividend yield.......................... 11.03%

Hanover applies APB Opinion No. 25 in accounting for its Stock Option Plans
and, accordingly, no compensation cost has been recognized for its stock options
in the financial statements for 2003. Had the Company determined compensation
cost based on the fair value at the grant date for its stock options under
Statement of Financial Accounting Standards No. 123, Accounting For Stock-Based
Compensation, the

13

HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Company's net income would have been reduced to the pro forma amounts: (dollars
in thousands, except per share data):

10. SUPPLEMENTAL DISCLOSURES FOR STATEMENTS OF CASH FLOWS
(in thousands, except share data)

11. SEGMENT REPORTING

As discussed in Note 1 to the Consolidated Financial Statements, the
Company is engaged in three principal businesses which are conducted through its
three primary operating units, each a reportable segment: Hanover, HCP and HT.
The principal business strategy of Hanover is to invest in MBS and mortgage
loans for its own account and for third parties. The principal business strategy
of HCP is to generate consulting and

14

HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

other fee income by providing consulting and due diligence services, focusing on
loan sale advisory, loan file due diligence reviews, staffing solutions and
mortgage assignment and collateral rectification services. HCP also services a
multifamily mortgage loan and owns a registered broker/dealer; these two
activities are not material and are combined with HCP for purposes of segment
reporting. The principal business activity of HT is to generate fee income by
operating an Internet exchange for trading mortgage loans, mortgage servicing
rights and related assets, and providing state-of-the-art technologies supported
by experienced valuation, operations and trading professionals. HT also owns a
broker/dealer whose activities are not material and are combined with HT for
segment reporting purposes.

As discussed in Note 1 to the Consolidated Financial Statements, for the
periods ending after June 30, 2002, Hanover's financial statements will be
consolidated with HCP and HT. Therefore, segment information is only being
provided for the three and six months ended June 30, 2003 as follows (dollars in
thousands):

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(a) Intersegment interest income and expense on notes from HCP and HT to
Hanover.

(b) Intersegment fee income from Hanover to HCP for assignment services.

(c) Intersegment fee income from HCP to HT for loan sale advisory services.

15

HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

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(a) Intersegment interest income and expense on notes from HCP and HT to
Hanover.

(b) Intersegment fee income from Hanover to HCP for assignment services.

(c) Intersegment fee income from Hanover and HCP to HT for loan sale advisory
services.

12. SUBSEQUENT EVENTS

On July 24, 2003, the Company filed a registration statement with the
Securities and Exchange Commission for a proposed public offering of 3,000,000
shares of common stock. The Company intends to use the proceeds from the
offering primarily to purchase subordinated mortgage-backed securities and other
mortgage-related assets.

On August 1, 2003, the Board of Directors declared a $0.30 per share cash
dividend for the quarter ended June 30, 2003 to be paid on August 15, 2003 to
stockholders of record as of August 8, 2003.

13. PRO FORMA DISCLOSURE

The following unaudited pro forma consolidated statements of income have
been prepared to give effect to Hanover's acquisition on July 1, 2002 of 100% of
the outstanding common stock of each of HCP, HT and HCP-2 (collectively, the
"Newly Consolidated Subsidiaries"), as previously reported on Form 8-K filed on
July 16, 2002. This acquisition had been accounted for using the purchase method
of accounting. These pro forma consolidated statements of income were prepared
as if the acquisition had been completed as of January 1, 2002.

The unaudited pro forma consolidated statements of income are presented for
illustrative purposes only and are not necessarily indicative of the results of
operations that would have actually been reported had the

16

HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

acquisition occurred on January 1, 2002, nor are these presentations necessarily
indicative of the future results of operations.

These unaudited pro forma consolidated statements of income are based upon
the historical consolidated financial statements of Hanover and the Newly
Consolidated Subsidiaries included in Hanover's Quarterly Report on Form 10-Q
for the three and six months ended June 30, 2002.

Information presented for the three and six months ended June 30, 2002 is
presented on a consolidated pro forma basis. Information presented for the three
and six months ended June 30, 2003 is presented on an actual basis, which takes
into account the consolidation of Hanover, HT, HCP and HCP-2.

17

HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES

PRO FORMA CONSOLIDATED STATEMENTS OF INCOME
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)

See notes to pro forma consolidated statements of income
18

HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES

PRO FORMA CONSOLIDATED STATEMENT OF INCOME
THREE MONTHS ENDED JUNE 30, 2002
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)

See notes to pro forma consolidated statements of income
19

HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES

PRO FORMA CONSOLIDATED STATEMENT OF INCOME
SIX MONTHS ENDED JUNE 30, 2002
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)

See notes to pro forma consolidated statements of income
20

HANOVER CAPITAL MORTGAGE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO PRO FORMA CONSOLIDATED STATEMENTS OF INCOME
THREE AND SIX MONTHS ENDED JUNE 30, 2002
(UNAUDITED)
(DOLLARS IN THOUSANDS)

(a) To eliminate intercompany interest income and expense summarized as
follows:

(b) Hanover engaged Hanover Capital Partners Ltd. pursuant to a Management
Agreement to render, among other things, due diligence, asset management and
administrative services. In addition, Hanover Capital Partners Ltd. performed
management and administrative services for HanoverTrade, Inc. To eliminate these
intercompany management fees recorded as follows:

(c) With the consolidation of the results of Hanover Capital Partners Ltd.,
HanoverTrade, Inc. and Hanover Capital Partners 2, Inc., the equity in income of
these subsidiaries summarized below would be reversed:

(d) To exclude the interest income on the portion of the notes receivable
reduced in exchange for the purchase of the common stock of the newly
consolidated subsidiaries; interest for the three and six months ended June 30,
2002 was forgiven and the offset is to personnel expense as follows:

21

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

IMPORTANT FACTORS RELATED TO FORWARD-LOOKING STATEMENTS AND ASSOCIATED RISKS

The following section, "Management's Discussion and Analysis of Financial
Condition and Results of Operations," should be read in conjunction with the
financial statements, related notes, and other detailed information included
elsewhere in this Quarterly Report on Form 10-Q. This report contains certain
"forward-looking statements" within the meaning of Section 27A of the Securities
Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934,
as amended. These forward-looking statements represent our current expectations,
intentions or beliefs regarding future events or trends, including, without
limitation, statements containing the words "believes," "anticipates,"
"expects," "intends," "assumes," "will," or other similar expressions; and also
including, without limitation, the following: statements regarding our
continuing ability to target, price and acquire mortgage-backed securities,
which we refer to as MBS, or mortgage loans; our estimated loan loss reserves;
our ability to manage and hedge the risks associated with our investments;
assumptions regarding interest rates and their effect on our hedging strategies;
the anticipated use of proceeds from our common stock offering; assumptions
regarding prepayment and default rates on the mortgage loans securing our MBS
and their effect on our hedging strategies; the liquidity of our portfolios and
our ability to invest currently liquid assets; the expected future performance
of Hanover Capital Partners and HanoverTrade and their need for additional
capital; continuing availability of the master reverse repurchase agreement
financing or other financing; the sufficiency of our working capital, cash flows
and financing to support our future operating and capital requirements; results
of operations and overall financial performance; the expected dividend
distribution rate; our ability to enter into additional asset management
contracts with third parties; our expectations regarding the effects of
accounting rules and changes thereto; changes in government regulations
affecting our business; and the expected tax treatment of our operations. Such
forward-looking statements relate to future events and our future financial
performance and involve known and unknown risks, uncertainties and other
important factors, many of which are beyond our control, which could cause
actual results, performance or achievements to differ materially from those
expressed or implied by such forward-looking statements.

In light of the risks and uncertainties inherent in all such projected
operational matters, the inclusion of forward-looking statements in this report
should not be regarded as a representation by us or any other person that our
objectives or plans will be achieved or that any of our operating expectations
will be realized. Our revenues and results of operations are difficult to
forecast and could differ materially from those projected in the forward-looking
statements contained in this report as a result of certain risks and
uncertainties including, but not limited to: changes in interest rates and the
yield curve; management of growth; changes in prepayment rates or default rates
on our mortgage assets; our ability to borrow at favorable rates and terms;
changes in business conditions and the general economy; our dependence on
effective information technology; potential declines in our ability to locate
and acquire desirable investments; changes in the real estate market both
locally and nationally; the effectiveness of our hedging and other efforts to
mitigate the risks of our investments; the effects of default, bankruptcy and
severe weather or natural disasters on the ability of borrowers to repay
mortgages included in our asset pools; enforceability and collectibility of
non-standard single-family mortgage loans; our ability to retain key employees;
our ability to maintain our qualification for exemption from registration as an
investment company; our ability to obtain and maintain all licenses necessary to
our business; competition from other financial institutions, including other
mortgage real estate investment trusts, or REITs; changes in government
regulation affecting our business and the possible changes in tax and other laws
applicable to REITs or our inability to maintain compliance with such rules and
to continue to qualify as a REIT. Investors should carefully consider the
various factors identified in "Management's Discussion and Analysis of Financial
Condition and Results of Operation -- Risk Factors," in our Annual Report on
Form 10-K for the year ended December 31, 2002, and in "Risk Factors" in our
Registration Statement on Form S-2 filed with the Securities and Exchange
Commission on July 24, 2003, as amended, that could cause actual results to
differ materially from the results predicted in the forward-looking statements.
These factors should not be considered exhaustive; we undertake no obligation to
release publicly the results of any future revisions we may make to
forward-looking statements to reflect events or circumstances after the date
hereof or to reflect the occurrence of unanticipated events.

22

Investors should also carefully consider the critical accounting policies
identified in "Management's Discussion and Analysis of Financial Condition and
Results of Operations -- Critical Accounting Policies," in our Annual Report on
Form 10-K for the year ended December 31, 2002. Certain critical accounting
policies are complex and involve significant judgment by our management,
including the use of estimates and assumptions that affect the reported amounts
of assets, liabilities, revenues and expenses. As a result, changes in these
estimates and assumptions could significantly affect our financial position or
our results of operations. We base our estimates on historical experience and on
various other assumptions that are believed to be reasonable under the
circumstances, the results of which form the basis for making judgments about
the carrying values of assets and liabilities. Actual results may differ from
these estimates under different assumptions or conditions. We believe our
critical accounting policies for mortgage securities, loan loss allowance,
equity investments, revenue recognition and income taxes involve a high degree
of judgment and complexity in the preparation of our consolidated financial
statements.

OVERVIEW

We are a specialty finance company organized in June 1997 as a REIT. At
June 30, 2003, we had two principal consolidated subsidiaries, Hanover Capital
Partners Ltd., which we refer to as HCP, and HanoverTrade, Inc., which we refer
to as HT. When we use the terms "we", "us", "our" or "the Company," we are
referring to our company and its consolidated and unconsolidated subsidiaries
taken as a whole. To provide more meaningful disclosure, we occasionally wish to
report information regarding only our REIT entity without reference to any of
its subsidiaries. In those instances, we refer to the REIT entity as "Hanover."

Hanover's principal business strategy is to invest in mortgage-backed
securities, known as MBS, and, to a lesser extent, mortgage loans and to earn
net investment income on these investments. HCP's principal business strategy is
to generate consulting and other fee income by performing loan sale advisory
services, loan file due diligence reviews, staffing solutions and mortgage
assignment and collateral rectification services. HT's principal business
strategy is to generate fee income by operating an Internet exchange for trading
mortgage loans, mortgage servicing rights and related assets, and providing
state-of-the-art technologies supported by experienced valuation, operations and
trading professionals. In addition to trading assets, HT provides a full range
of asset valuation, analysis and marketing services for: mortgage-related
assets. In addition, Hanover has an equity interest in HDMF-I LLC, a limited
liability company formed to purchase, service, manage or otherwise liquidate
pools of primarily sub- and non-performing one-to-four family residential
mortgage loans.

Hanover operates as a tax-advantaged REIT and is generally not subject to
Federal and state income tax to the extent that it distributes its taxable
earnings to its stockholders and maintains its qualification as a REIT.
Hanover's taxable affiliates, however, are subject to Federal and state income
tax. Hanover has engaged HCP to render due diligence, asset management and
administrative services pursuant to a Management Agreement.

In conducting our business, we retain credit risk primarily through (i) the
purchase of subordinate mortgage securities, (ii) the retention of subordinate
securities from our own securitization transactions, (iii) the direct investment
in mortgage loans on our own behalf and (iv) investment in HDMF-I. Through these
investing activities, we generally bear the credit losses on the related pools
of mortgage loans up to their carrying value. During the time we hold mortgage
assets for investment, we are subject to the risks of borrower defaults and
bankruptcies and hazard losses (such as those occurring from earthquakes or
floods) that are not covered by insurance. If a default occurs on any mortgage
loan held by us or on any mortgage loan collateralizing below-investment-grade
MBS held by us, we will bear the risk of loss of principal to the extent of any
deficiency between the value of the mortgaged property, plus any payments from
an insurer or guarantor, and the amount owing on the mortgage loan.

23

As of June 30, 2003, we retain the aggregate credit risk on $17.4 billion
of mortgage loans relating to (dollars in thousands):

The above carrying value of collateral for CMOs is our net invested equity
in retained mortgage-backed bonds.

In addition, HDMF-I retains the aggregate credit risk on $6,082,000 of
mortgage loans.

On July 1, 2002, Hanover acquired 100% of the outstanding capital stock of
each of HT, HCP, and Hanover Capital Partners 2, Inc., which we refer to as
HCP-2. Hanover had previously owned 100% of the non-voting preferred stock, but
none of the voting common stock, of each of these entities. Prior to July 1,
2002, the financial results for these three entities appeared in our financial
statements as a single line-item under "equity in income or loss of
unconsolidated subsidiaries." Due to the stock purchase, for periods ending
after June 30, 2002, Hanover's financial statements will be consolidated with
the financial statements of those entities. This means that the financial
results for these three entities, whether positive or negative, will appear
throughout our financial statements as applicable, rather than in a single
line-item. To assist you in evaluating the effect of the stock purchase on our
financial results, our discussion below sometimes includes information regarding
both "previously reported" and "pro forma" financial results. "Previously
reported" financial results provide the actual results for the periods
presented, which means that they do not give effect to the stock purchase for
any periods prior to July 1, 2002. "Pro forma" financial results provide
financial information for the periods shown as if the stock purchase of HT, HCP
and HCP-2 had been completed as of January 1, 2002 for statement of income
purposes. "Pro forma" financial information is presented for illustrative
purposes only. Pro forma information is not necessarily indicative of the
financial position or results of operations that would have been reported had
the acquisition occurred on January 1, 2002, and these presentations do not
necessarily indicate the future financial position or results of operations.

24

RESULTS OF OPERATIONS

The following table presents the consolidated results of operations as
previously reported for the three and six months ended June 30, 2003 and 2002
and pro forma results for the three and six months ended June 30, 2002 (dollars
in thousands, except per share data):

NET INCOME, BASIC EARNINGS PER SHARE AND TOTAL REVENUE

We recorded net income of $2,507,000 or $0.56 per share based on 4,504,091
weighted average shares of common stock outstanding for the three months ended
June 30, 2003 compared to net income of $1,392,000 or $0.32 per share based on
4,387,285 weighted average common shares outstanding for the three months ended
June 30, 2002. We recorded net income of $5,056,000 or $1.12 per share based on
4,500,965 weighted average shares of common stock outstanding for the six months
ended June 30, 2003 compared to net income of $2,704,000 or $0.62 per share
based on 4,345,052 weighted average common shares outstanding for the six months
ended June 30, 2002. Total revenue for the three months ended June 30, 2003 was
$7,554,000 compared to $1,666,000 previously reported for the same period in
2002. On a pro forma basis, total revenue for the three months ended June 30,
2002 was $5,691,000. Total revenue for the six months ended June 30, 2003 was
$14,896,000 compared to $3,967,000 previously reported for the same period in
2002. On a pro forma basis, total revenue for the six months ended June 30, 2002
was $11,159,000.

25

NET INTEREST INCOME AND LOAN LOSS PROVISION

The following table provides details of net interest income and loan loss
provision for interest earning assets as follows:

NET INTEREST INCOME

Net interest income increased to $1,443,000, or $0.32 per share, for the
three months ended June 30, 2003 from $1,381,000, or $0.31 per share, as
previously reported for the same period in 2002. The increase in net interest
income of $62,000 was primarily due to:

- the decrease in the average balance of our mortgage loans held as
collateral for collateralized mortgage obligations, called CMOs, offset
by decreased borrowing costs on our corresponding CMO liabilities and
reverse repurchase agreements;

- the purchase of Agency-issued MBS; and

- the decrease in the interest earned from interest-only notes retained
from our 1998-B securitization offset by the increase in the average
balance of our purchased subordinate MBS portfolio.

During December 2002 and January 2003, we exercised call provisions in our
Hanover 1998-A and 1998-B securitizations and sold the underlying mortgage loans
in February and March 2003. As a result of the two sales, we invested
approximately $6,000,000 of capital during the second quarter of 2003.

Net interest income from Agency-issued MBS increased in the three months
ended June 30, 2003 because of renewed investment activity in such MBS.

Private placement MBS net interest income increased due to the purchase of
subordinate MBS during the second quarter of 2003. The average balance of our
subordinate MBS portfolio increased to $20,774,000 for the second quarter 2003
from $10,935,000 for the second quarter 2002. The decrease in net interest
income recognized from interest-only notes retained from our 1998-B
securitization resulted from the collapse of Hanover 1998-B in the first quarter
2003.

On a pro forma basis, net interest income increased to $1,443,000 for the
three months ended June 30, 2003 from $1,359,000 for the same period in 2002.
The $22,000 adjustment required on a pro forma basis from that previously
reported for second quarter 2002 is the elimination of $181,000 of interest
income on intercompany notes and $7,000 of interest income on the portion of the
notes receivable reduced in exchange for the purchase of the common stock of
HCP, HT and HCP-2 offset by $166,000 of interest income from HCP and HCP-2 that
was previously reported as a component of equity in income from unconsolidated
subsidiaries.

26

Net interest income decreased to $2,553,000, or $0.57 per share, for the
six months ended June 30, 2003 from $3,033,000, or $0.70 per share, as
previously reported for the same period in 2002. The decrease in net interest
income of $480,000 was primarily due to:

- the decrease in the average balance of our mortgage loans held as
collateral for CMOs offset by decreased borrowing costs on our
corresponding CMO liabilities and reverse repurchase agreements;

- the decrease in the average balance of our Agency-issued MBS portfolio;
and

- the decrease in the interest earned from interest-only notes retained
from our 1998-B securitization offset by the increase in the average
balance of our purchased subordinate MBS portfolio.

During December 2002 and January 2003, we exercised call provisions in our
Hanover 1998-A and 1998-B securitizations and sold the underlying mortgage loans
in February and March 2003. As a result of the two sales, we invested
approximately $6,000,000 of capital during the second quarter of 2003.

Net interest income from Agency-issued MBS decreased in the six months
ended June 30, 2003 because, although we renewed our investment activity during
the second quarter of 2003, the average balance decreased to $9,614,000 for the
six months ended June 30, 2003 from $13,448,000 for the same period in 2002.

Private placement MBS net interest income increased due to the purchase of
subordinate MBS during the first six months 2003. The average balance of our
subordinate MBS portfolio increased to $18,325,000 for the first six months 2003
from $10,793,000 for the first six months 2002. The decrease in net interest
income recognized from interest-only notes retained from our 1998-B
securitization resulted from the collapse of Hanover 1998-B in the first quarter
2003.

On a pro forma basis, net interest income decreased to $2,553,000 for the
six months ended June 30, 2003 from $3,324,000 for the same period in 2002. The
$291,000 adjustment required on a pro forma basis from that previously reported
for second quarter 2002 is the elimination of $332,000 of interest income on
intercompany notes and $13,000 of interest income on the portion of the notes
receivable reduced in exchange for the purchase of the common stock of HCP, HT
and HCP-2 offset by $636,000 of interest income from HCP and HCP-2 that was
previously reported as a component of equity in income from unconsolidated
subsidiaries.

Our provision for loan losses increased to $408,000 in the three months
ended June 30, 2003 from $67,000 for the same period in 2002 and $679,000 for
the six months ended June 30, 2003 from $121,000 for the same period in 2002.
The increases for the three and six months ended June 30, 2003 compared to
similar periods last year were primarily the result of purchases of first-loss
subordinate MBS offset by a reduction in the average balance of collateral for
CMOs. First-loss subordinate MBS are generally structured to absorb the credit
losses resulting from a specified pool of mortgages. As a result, we provide for
the estimated losses associated with first-loss subordinate MBS, which increases
our overall loan loss allowance. If our loss estimates differ materially from
actual results, we could incur additional losses resulting in decreased net
income in future periods. No adjustments were required on a pro forma basis
because the provision for loan losses relates solely to Hanover during these
periods.

GAIN ON SALE AND MARK TO MARKET OF MORTGAGE ASSETS

Our results for the three months ended June 30, 2003 include a gain on sale
of mortgage assets of $2,494,000 compared to $305,000 for the same period in
2002. No adjustments were required on a pro forma basis because gain on sale of
mortgage assets relates only to Hanover during these periods. During the three
months ended June 30, 2003, we sold approximately $8,084,000 principal balance
of subordinate MBS as compared to sales of $2,232,000 principal balance of
subordinate MBS during the same period in 2002.

Our results for the six months ended June 30, 2003 include a gain on sale
of mortgage assets of $5,777,000 compared to $905,000 for the same period in
2002. No adjustments were required on a pro forma basis because gain on sale of
mortgage assets relates only to Hanover during these periods. We cannot assure
you that we will be able to recognize gain on sale in the future. As a REIT, we
do not actively trade our mortgage assets.
27

The gain on sale for the six months ended June 30, 2003 primarily
represents the sales of mortgage loans that supported certain CMOs, which we
refer to as Hanover 1998-A and Hanover 1998-B. These sales resulted in aggregate
net proceeds of $7,281,000, cash available for reinvestment of approximately
$6,000,000 and a gain of $3,161,000. In addition, during the six months ended
June 30, 2003, we sold approximately $12,520,000 principal balance of
subordinate MBS as compared to sales of $6,862,000 principal balance of
subordinate MBS during the same period in 2002.

Our purchased subordinate MBS portfolio is primarily comprised of
non-investment-grade securities. These securities are generally purchased at a
substantial discount to their principal balance to reflect their inherent credit
risk. To the extent that actual losses on the mortgage asset are less than the
discount, the discount provides a yield enhancement. We seek to reduce credit
risk by actively monitoring our portfolio for delinquency trends and due to such
monitoring we may, from time to time, decide to sell a security in order to
mitigate potential losses.

For the three and six months ended June 30, 2002, we recognized mark to
market gains or losses on mortgage assets classified as trading securities
through our Consolidated Statement of Income. Mortgage assets classified as
available for sale are marked to market through other comprehensive income. We
recognized mark to market gains on our purchased subordinate MBS portfolio of
$300,000 and $575,000 for the three and six months ended June 30, 2002,
respectively. Market gains or losses on our purchased subordinate portfolio are
primarily subject to assumptions on the underlying mortgage loan portfolio
including, but not limited to, prepayment speed assumptions, future loss
assumptions and changes in the benchmark interest rate. We recognized mark to
market gains of $18,000 for the three and six months ended June 30, 2003.

OTHER REVENUE

Revenues from due diligence increased to $1,433,000 for the three months
ended June 30, 2003 from $0 for the same period in 2002. Revenues from
assignment fees increased to $641,000 for the three months ended June 30, 2003
from $0 for the same period in 2002. Revenues from technology increased to
$927,000 for the three months ended June 30, 2003 from $0 for the same period in
2002. Revenues from loan brokering, trading and advisory services increased to
$948,000 for the three months ended June 30, 2003 from $0 for the same period in
2002. In each case, this is because in periods prior to the consolidation of
Hanover, HCP, HT and HCP-2, we did not separately record revenues attributable
to HT, HCP or HCP-2, and all of the revenues listed in this paragraph are
derived from the activities of HT and HCP.

On a pro forma basis, revenues from due diligence increased to $1,433,000
for the three months ended June 30, 2003 from $1,163,000 for the same period in
2002. Total due diligence revenues increased due to an increase in our number of
clients offset by a decrease in revenue from our largest clients. On a pro forma
basis, revenues from assignment fees increased to $641,000 for the three months
ended June 30, 2003 from $444,000 for the same period in 2002, primarily because
of 1 large assignment contract. This contract accounted for approximately 67% of
the total assignment fees recognized during the three months ended June 30,
2003. We cannot assure you that we will be able to generate assignment fees
comparable to those recorded for the three months ended June 30, 2003. On a pro
forma basis, revenues from technology increased to $927,000 for the three months
ended June 30, 2003 from $25,000 for the same period in 2002. Technology revenue
was derived from the licensing of our proprietary software and consulting
services performed in connection with such licenses. Minimal technology revenue
was generated for the three months ended June 30, 2002. Of the $927,000 of
technology revenue generated for the three months ended June 30, 2003, 96% was
derived from 2 clients. We cannot assure you that we will be able to generate
technology revenues comparable to those recorded for the three months ended June
30, 2003. On a pro forma basis, revenues from loan brokering, trading and
advisory services decreased to $948,000 for the three months ended June 30, 2003
from $2,330,000 for the same period in 2002. This decrease is primarily
attributable to completion of a large contract with the FDIC during 2002. We
cannot assure you that comparable contracts will be available in the future.

Revenues from due diligence increased to $2,752,000 for the six months
ended June 30, 2003 from $0 for the same period in 2002. Revenues from
assignment fees increased to $1,214,000 for the six months ended June 30, 2003
from $0 for the same period in 2002. Revenues from technology increased to
$1,812,000 for the

28

six months ended June 30, 2003 from $0 for the same period in 2002. Revenues
from loan brokering, trading and advisory services increased to $1,344,000 for
the six months ended June 30, 2003 from $0 for the same period in 2002. In each
case, this is because in periods prior to the consolidation of Hanover, HCP, HT
and HCP-2, we did not separately record revenues attributable to HT, HCP or
HCP-2, and all of the revenues listed in this paragraph are derived from the
activities of HT and HCP.

On a pro forma basis, revenues from due diligence increased to $2,752,000
for the six months ended June 30, 2003 from $2,079,000 for the same period in
2002. Total due diligence revenues increased due to an increase in our number of
clients offset by a decrease in revenue from our largest clients. On a pro forma
basis, revenues from assignment fees increased to $1,214,000 for the six months
ended June 30, 2003 from $833,000 for the same period in 2002, primarily because
of 1 large assignment contract. This contract accounted for approximately 65% of
the total assignment fees recognized to date in 2003. We cannot assure you that
we will be able to generate assignment fees comparable to those recorded for the
six months ended June 30, 2003. On a pro forma basis, revenues from technology
increased to $1,812,000 for the six months ended June 30, 2003 from $47,000 for
the same period in 2002. Technology revenue was derived from the licensing of
our proprietary software and consulting services performed in connection with
such licenses. Minimal technology revenue was generated for the six months ended
June 30, 2002. Of the $1,812,000 of technology revenue generated for the six
months ended June 30, 2003, 97% was derived from 2 clients. We cannot assure you
that we will be able to generate technology revenues comparable to those
recorded for the six months ended June 30, 2003. On a pro forma basis, revenues
from loan brokering, trading and advisory services decreased to $1,344,000 for
the six months ended June 30, 2003 from $4,145,000 for the same period in 2002.
This decrease is primarily attributable to completion of a large contract with
the FDIC during 2002. We cannot assure you that comparable contracts will be
available in the future.

OPERATING EXPENSES

Operating expenses for the three months ended June 30, 2003 were $4,990,000
compared to $964,000 as previously reported for the same period in 2002 and
$4,255,000 on a pro forma basis for the same period in 2002. The biggest
component of the increase, on a pro forma basis, was an increase in
subcontractor expenses. Subcontractor expenses for the three months ended June
30, 2003 increased to $933,000 compared to, on a pro forma basis, $643,000 for
the same period last year. The increase in subcontractor expenses is primarily
due to the increase in the number of due diligence projects in the second
quarter 2003 as compared to the same period in 2002. In addition, the mix of due
diligence projects changed to require an increase in the use of subcontractors
for the second quarter 2003 as compared to the second quarter 2002 where
in-house personnel performed more projects. Another component of the increase in
operating expenses was in personnel expenses which increased to $2,387,000 for
the three months ended June 30, 2003 compared to, on a pro forma basis,
$2,126,000 for the same period last year. The increase in personnel expenses is
primarily due to $296,000 of compensation expense recorded pursuant to our bonus
incentive compensation plan compared to $148,000 for the comparable period in
2002. This additional compensation is based on having met certain performance
targets established during the formation of the Company.

Operating expenses for the six months ended June 30, 2003 were $9,716,000
compared to $2,010,000 as previously reported for the same period in 2002 and
$8,353,000 on a pro forma basis for the same period in 2002. The biggest
component of the increase, on a pro forma basis, was an increase in
subcontractor expenses. Subcontractor expenses for the six months ended June 30,
2003 increased to $1,873,000 compared to, on a pro forma basis, $1,144,000 for
the same period last year. The increase in subcontractor expenses is primarily
due to the increase in the number of due diligence projects in the six months
2003 as compared to the same period in 2002. In addition, the mix of due
diligence projects changed to require an increase in the use of subcontractors
for the six months 2003 as compared to the six months 2002 where in-house
personnel performed more projects. Another component of the increase in
operating expenses was in personnel expenses which increased to $4,565,000 for
the six months ended June 30, 2003 compared to, on a pro forma basis, $4,322,000
for the same period last year. The increase in personnel expenses is primarily
due to an increase in the number of employees.

29

EQUITY IN INCOME (LOSS) OF UNCONSOLIDATED SUBSIDIARIES

HDMF-I is a limited liability company whose objective is to purchase,
service and manage pools of primarily sub- and non-performing one-to-four family
residential whole loans. In November 2001, we made our initial investment in
HDMF-I of $115,000 to fund our proportionate share of professional,
organizational and other fees of HDMF-I. In the first quarter of 2002, we
invested an aggregate of $3,891,000 in HDMF-I to fund our proportionate share of
a loan pool with a purchase price of $12,230,000. In the second half of 2002, we
invested an additional $1,968,000 in HDMF-I to fund the purchase price of an
additional loan pool and received $1,458,000 in distributions from HDMF-I. For
the three months ended June 30, 2003, we recognized equity in income of $3,000
compared to $20,000 for the comparable period in 2002. For the six months ended
June 30, 2003, we recognized equity in losses of $40,000 compared to equity in
losses of $1,000 for the comparable period in 2002. During the six months ended
June 30, 2003, we received $2,911,000 in additional distributions from HDMF-I.
At June 30, 2003, we had a total capital contribution commitment of $5,820,000.

TAXABLE INCOME

Our taxable loss for the quarter ended June 30, 2003 is estimated at
$295,000. Taxable loss differs from GAAP net income due to various recurring and
one-time book/tax differences. The following table details the major book/tax
differences in arriving at the estimated taxable loss (dollars in thousands):

GAAP net income............................................. $ 2,507
GAAP gain on sale of mortgage securities.................. (2,496)
Tax gain on sale of mortgage securities................... 2,615
Utilization of capital loss carryforward.................. (2,615)
Deductible expenses relating to principals' loan
forgiveness............................................ (583)
Loan loss provision, net of realized losses............... 408
Income in subsidiaries not included in taxable loss....... (147)
Other..................................................... 16
--------
Estimated taxable loss...................................... $ (295)
========

We believe that estimated taxable loss provides useful information to
investors because it provides information relating to our dividends and REIT
status.

As a REIT, we are required to pay dividends amounting to 85% of each year's
taxable ordinary income and 95% of the portion of each year's capital gain net
income that is not taxed at the REIT level, by the end of each calendar year and
to have declared dividends amounting to 90% of our REIT taxable income for each
year by the time we file our Federal tax return. Therefore, a REIT generally
passes through substantially all of its earnings to shareholders without paying
Federal income tax at the corporate level. Dividend payments for 2003 may
represent a partial return of capital dividend to shareholders.

If we fail to qualify as a REIT in any taxable year and certain relief
provisions of the Code do not apply, we will be subject to Federal income tax as
a regular, domestic corporation, and our stockholders will be subject to tax in
the same manner as stockholders of a regular corporation. Distributions to our
stockholders in any year in which we fail to qualify as a REIT would not be
deductible by us in computing our taxable income. As a result, we could be
subject to income tax liability, thereby significantly reducing or eliminating
the amount of cash available for distribution to our stockholders. Further, we
could also be disqualified from re-electing REIT status for the four taxable
years following the year during which we became disqualified. At the same time,
complying with REIT requirements may limit our ability to hedge our risks, or
enter into otherwise attractive investments.

LIQUIDITY AND CAPITAL RESOURCES

On August 14, 2003 we announced the pricing of a public offering of
3,000,000 shares of our common stock at $10.00 per share, for estimated net
proceeds to us of approximately $27.4 million. The underwriters

30

have a 30-day option to purchase up to 450,000 additional shares of our common
stock solely to cover over-allotments, if any. All of the shares of common stock
are being offered pursuant to an effective registration statement previously
filed with the Securities and Exchange Commission. We intend to use the net
proceeds from the offering primarily to purchase subordinated mortgage-backed
securities and other mortgage-related assets. We expect to meet our future
short-term and long-term liquidity requirements generally from the proceeds of
our common stock offering, our existing working capital, cash flow provided by
operations, reverse repurchase agreements and other possible sources of
longer-term financing, including CMOs and REMICs. We consider our ability to
generate cash to be adequate to meet operating requirements both in the
short-term and the long-term. However, we have exposure to market-driven
liquidity events due to the short-term reverse repurchase financing we have in
place against our MBS. If a significant decline in the market value of our
portfolio should occur, our available liquidity from existing sources and
ability to access additional sources of credit could be reduced. As a result of
such a reduction in liquidity, we may be forced to sell certain investments or
incur debt to maintain liquidity. If required, these sales could be made at
prices lower than the carrying value of such assets, which could result in
losses. At June 30, 2003, we had one committed reverse repurchase line of credit
with $10 million available and six uncommitted lines of credit. We may seek to
establish additional committed and uncommitted lines of credit in the future. We
cannot assure you that we will be successful in obtaining such additional
financing on favorable terms, if at all.

Net cash provided by operating activities for the six months ended June 30,
2003 was $1,458,000 compared to net income of $5,056,000 for the same period in
2003. Sales of trading securities provided $3,267,000, partially offset by the
gain on sale of mortgage assets of $5,777,000.

Net cash used in investing activities amounted to $4,975,000 during the six
months ended June 30, 2003. The majority of cash proceeds from investing
activities was generated from (i) principal payments received on collateral for
CMOs of $14,327,000, (ii) proceeds from sale of mortgage assets of $40,272,000
and (iii) principal payments received on mortgage securities of $885,000. These
proceeds were partially offset by purchases of mortgage securities of
$60,452,000.

Cash flows provided by financing activities for the six months ended June
30, 2003 was $4,980,000. We made repayments on CMO borrowings of $39,679,000
partially offset by borrowings on reverse repurchase agreements of $48,036,000.
We also paid dividends of $3,125,000.

We regularly invest our capital in MBS through Hanover, our primary
investment vehicle. Hanover's securitizations were issued with various call
provisions, generally allowing for the termination of the securitization at the
earlier of a certain date or when the outstanding collateral balance is less
than a certain percentage of the original collateral balance. During December
2002, Hanover exercised the call provisions of its 1998-A securitization. In
February 2003, Hanover sold the underlying mortgage loans and realized aggregate
net proceeds of $1,365,000. As of December 31, 2002, Group 3 of Hanover's 1998-B
securitization was callable. During January 2003, Hanover exercised the call
provisions of its 1998-B securitization and in March 2003, sold the underlying
mortgage loans and realized aggregate net proceeds of $5,930,000. Cash available
for reinvestment from these sales is approximately $6,000,000.

Although we have no immediate plans for a change in the ownership of HT, we
continue to pursue third-party investments to address HT's future capitalized
software budget and operating needs. If outside financing is not located, we
will continue to be responsible for HT's capital and operating requirements,
although we do not expect those needs to be substantial in 2003.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We use certain derivative financial instruments as hedges of anticipated
transactions relating to our mortgage securities.

From time to time, we enter into forward sales of mortgage securities
issued by federal agencies to manage our exposure to market pricing changes in
connection with the purchase, holding, securitization and sale of our fixed-rate
mortgage loan portfolio and other mortgage securities. We generally close out
the hedge position to coincide with the related sale or securitization
transaction. As such hedges are considered

31

freestanding derivatives for accounting purposes, we recognize changes in the
fair value of such hedges in earnings in the period of change. At June 30, 2003,
we had no forward commitments to sell or buy agency-issued mortgage securities.

The primary risk associated with short-selling agency-issued securities
relates to changes in interest rates. Generally, as market interest rates
increase, the market value of the hedged asset (fixed-rate mortgage loans) will
decrease. The net effect of increasing interest rates will generally be a
favorable or gain settlement on the forward sale of the agency-issued security;
this gain should offset a corresponding decline in the value of the hedged
assets. Conversely, if interest rates decrease, the market value of the hedged
asset will generally increase. The net effect of decreasing interest rates will
generally be an unfavorable or loss settlement on the forward sale of the
agency-issued security; this loss should be offset by a corresponding gain in
value of the hedged assets. To mitigate interest rate risk, an effective
matching of agency-issued securities with the hedged assets needs to be
monitored closely. Senior management monitors the changes in weighted average
duration and coupons of the hedged assets and will appropriately adjust the
amount, duration and coupon of future forward sales of agency-issued securities.

We also enter into interest rate caps to manage our interest rate exposure
on certain reverse repurchase financing and floating rate CMOs. For interest
rate caps designated as freestanding derivatives for accounting purposes,
changes in fair value are recognized in earnings in the period of change.

As of June 30, 2003, we had the following interest rate caps in effect
(dollars in thousands):

The primary risk associated with interest rate caps relates to interest
rate increases. The interest rate caps provide a cost of funds hedge against
interest rates that exceed the strike rate, subject to the limitation of the
notional amount of financing. As of June 30, 2003, the fair value of our
interest rate caps was $1,000; also the maximum potential loss exposure due to
unfavorable market movements.

INTEREST RATE SENSITIVITY

INTEREST RATE MISMATCH RISK -- REVERSE REPURCHASE FINANCING

As of June 30, 2003, we owned $464,000 of mortgage loans held for sale. In
general, we expect that future loan purchases will be conducted by HDMF-I, and
we do not currently plan to purchase additional loans for our own account. If we
resume our strategy of purchasing mortgage loans for our own account, we would
finance these assets during the initial period (the time period during which
management analyzes the loans in detail and corrects deficiencies where possible
before securitizing the loans) with reverse repurchase agreement financing or
with equity. In this scenario, we would be exposed to the mismatch between the
cost of funds on our reverse repurchase agreement financing and the yield on the
mortgage loans. Our reverse repurchase agreement financing as of June 30, 2003
was indexed to LIBOR plus a spread of 40 to 200 basis points. This financing
generally is rolled and matures every 30 to 90 days.

Accordingly, any increases in LIBOR will tend to reduce net interest income
and any decreases in LIBOR will tend to increase net interest income.

We also have floating-rate reverse repurchase financing for certain
fixed-rate MBS. As of June 30, 2003, we had a total of $48,566,000 of
floating-rate reverse repurchase financing for $55,443,000 of fixed-rate MBS
investments. We have attempted to hedge this exposure by using the interest rate
caps described above.

PRICE RISK

The market value of mortgage loans and mortgage securities will fluctuate
with changes in interest rates. In the case of mortgage loans held for sale and
mortgage securities available for sale or held for trading, we will be required
to record changes in the market value of such assets. In the case of mortgage
loans held for

32

sale and mortgage securities held for trading, we generally attempt to hedge
these changes through the short sale of mortgage securities, described above. As
of June 30, 2003, we did not have any significant mortgage loans held for sale.
We hedge the mortgage securities held for trading with the short sale of
mortgage securities described above.

PREPAYMENT RISK

Interest income on the mortgage loan and mortgage securities portfolio is
also negatively affected by prepayments on mortgage loan pools or MBS purchased
at a premium and positively impacted by prepayments on mortgage loan pools or
MBS purchased at a discount. We assign an anticipated prepayment speed to each
mortgage pool and MBS at the time of purchase and record the appropriate
amortization of the premium or discount over the estimated life of the mortgage
loan pool or MBS. To the extent the actual prepayment speeds vary significantly
from the anticipated prepayment speeds for an extended period of time, we will
adjust the anticipated prepayment speeds and amortization of the premium or
discount accordingly. This will negatively (in the case of accelerated
amortization of premiums or decelerated amortization of discounts) or positively
(in the case of decelerated amortization of premiums or accelerated amortization
of discounts) impact net interest income.

SECURITIZED MORTGAGE LOAN ASSETS

With respect to the matched funding of assets and liabilities, the CMO
collateral relating to the 1999-A, 1999-B and 2000-A securitizations reflect
$43,587,000 of fixed-rate mortgage loans and $27,022,000 of adjustable-rate
mortgage loans. The primary financing for this asset category is the CMO debt of
$64,002,000 and reverse repurchase agreements of $1,437,000. The reverse
repurchase agreement financing, which is indexed to LIBOR, is subject to
interest rate volatility as the reverse repurchase agreement matures and is
extended. The financing provided by the CMOs for the 1999-A and 2000-A
securitizations lock in long-term fixed financing and thereby eliminates most
interest rate risk. The financing for the 1999-B securitization is indexed to
LIBOR. Accordingly, we have hedged this interest rate risk through the purchase
of interest rate caps. We purchased amortizing interest rate caps with notional
balances of $110 million in August 1999 to hedge the 1999-B securitization. The
remaining notional balance of these caps is $20 million at June 30, 2003.

MORTGAGE SECURITIES

As of June 30, 2003, we owned certain fixed-rate Agency-issued mortgage
securities and certain fixed-rate and adjustable-rate private placement mortgage
securities with an aggregate carrying value of $72,593,000. The coupon interest
rates on the fixed-rate mortgage securities would not be affected by changes in
interest rates.

ITEM 4. CONTROLS AND PROCEDURES

(a) As of the end of the period covered by this report, we carried out an
evaluation, under the supervision and with the participation of our management,
including our Chief Executive Officer and Chief Financial Officer, of the
effectiveness of the design and operation of our disclosure controls and
procedures pursuant to Rule 13a-15 under the Securities Exchange Act of 1934, as
amended. Based upon that evaluation, our Chief Executive Officer and Chief
Financial Officer concluded that our disclosure controls and procedures are
effective in timely alerting them to material information required to be
included in our periodic SEC filings. However, we cannot assure you that our
controls and procedures can prevent or detect all errors and fraud. In addition,
since any system of controls is based in part upon assumptions regarding future
events, we cannot assure you that the design of our controls will be successful
in achieving its stated goals under all potential future conditions.

(b) There have been no changes in our internal control over financial
reporting that occurred during the second quarter of 2003 that have materially
affected, or are reasonably likely to materially affect, our internal control
over financial reporting.

33

PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

From time to time we are involved in litigation incidental to the conduct
of our business. We are not currently a party to any lawsuit or proceeding
which, in the opinion of management, is likely to have a material adverse effect
on our business, financial condition or results of operations.

ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS

Not applicable.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

Not applicable.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

We held our annual meeting of stockholders on May 15, 2003. 4,532,402
shares of our common stock were outstanding and entitled to vote at the annual
meeting, and 4,444,279 shares were represented at the annual meeting in person
or by proxy. The following matters were voted upon at the annual meeting:

(a) The following members were re-elected to the Board of Directors:

The six other members of the Board of Directors will continue in office
after the annual meeting for the following terms:

Terms expiring in 2004: George J. Ostendorf, John N. Rees and Joseph J.
Freeman.
Terms expiring in 2005: James F. Stone, Joyce S. Mizerak and Irma N.
Tavares.

(b) The appointment of Deloitte & Touche LLP as independent accountants to
audit and report on our financial statements for fiscal year 2003 was ratified
by the stockholders with the following vote:

There were no broker non-votes.

ITEM 5. OTHER INFORMATION

Not applicable.

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

(a) Exhibits

The exhibits listed on the Exhibit Index, which appears immediately
following the signature page below, are included or incorporated by reference
herein.

(b) Reports on Form 8-K

On May 19, 2003, we furnished on Form 8-K a transcript of our first quarter
conference call and disclosure related to a possible non-GAAP financial measure,
as defined under Regulation G, included in the conference call.

34

On July 25, 2003, we furnished on Form 8-K a press release relating to a
registration statement filed with the Securities and Exchange Commission for a
proposed public offering of 3,000,000 shares of common stock.

On August 5, 2003, we furnished on Form 8-K a press release relating to our
financial performance for the second quarter 2003 and other matters.

35

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.

HANOVER CAPITAL MORTGAGE HOLDINGS,
INC.

By: /s/ JOHN A. BURCHETT
------------------------------------
John A. Burchett
President and Chief Executive
Officer
Chairman of the Board of Directors
(Principal Executive Officer)

Dated: August 14 , 2003

By: /s/ J. HOLLY LOUX
------------------------------------
J. Holly Loux
Chief Financial Officer
(Principal Financial and
Accounting Officer)

Dated: August 14, 2003

36

EXHIBIT INDEX

- ---------------

* Filed herewith.

** Furnished herewith.

(1) Incorporated herein by reference to Registrant's Registration Statement on
Form S-11, Registration No. 333-29261, as amended, which became effective
under the Securities Act of 1933, as amended, on September 15, 1997.

(2) Incorporated herein by reference to Registrant's Form 10-K for the year
ended December 31, 1997, as filed with the Securities and Exchange
Commission on March 31, 1998.

(3) Incorporated herein by reference to Registrant's Form 10-K for the year
ended December 31, 1999, as filed with the Securities and Exchange
Commission on March 30, 2000.

(4) Incorporated herein by reference to Registrant's Form 10-Q for the quarter
ended March 31, 2000, as filed with the Securities and Exchange Commission
on May 15, 2000.

(5) Incorporated herein by reference to Registrant's report on Form 8-K filed
with the Securities and Exchange Commission on April 24, 2000.

(6) Incorporated herein by reference to Registrant's Form 10-K for the year
ended December 31, 2000, as filed with the Securities and Exchanges
Commission on April 2, 2001.

(7) Incorporated herein by reference to Registrant's Form 10-Q for the quarter
ended June 30, 2001, as filed with the Securities and Exchange Commission
on August 14, 2001.

(8) Incorporated herein by reference to Registrant's Form 8-K filed with the
Securities and Exchange Commission on July 16, 2002.

(9) Incorporated herein by reference to Registrant's Form 10-Q for the quarter
ended June 30, 2002, as filed with the Securities and Exchange Commission
on August 14, 2002.

(10) Incorporated herein by reference to Registrant's Form 10-K for the year
ended December 31, 2002, as filed with the Securities and Exchange
Commission on March 28, 2003.

(11) Incorporated herein by reference to Registrant's Form 10-Q for the quarter
ended March 31, 2003, as filed with the Securities and Exchange Commission
on May 15, 2003.